MacroScan (Printable Version) - The End of Development Finance

Close to two years back, on March 30 2002, the Industrial Credit and Investment Corporation of India (ICICI) was through a reverse merger, integrated with ICICI Bank. That was the beginning of a process that is leading to the demise of development finance in the country. The reverse merger was the result of a decision (announced on October 25, 2001) by the ICICI to transform itself into a universal bank that would engage itself not only in traditional banking, but also investment banking and other financial activities. The proposal also involved merging ICICI Personal Financial Services Ltd and ICICI Capital Services Ltd with the bank, resulting in the creation of a financial behemoth with assets of more than Rs. 95,000 crore. The new company was to become the first entity in India to serve as a financial supermarket and offer almost every financial product under one roof.

Since the announcement of that decision, not only has the merger been put through, but similar moves are underway to transform the other two principal development finance institutions in the country, the Industrial Finance Corporation of India (IFCI), established in 1948, and the Industrial Development Bank of India (IDBI), created in 1964. In early February, Finance Minister Jaswant Singh announced the government's decision to merge the IFCI with a big public sector bank, like the Punjab National Bank. Following that decision, the IFCI board has approved the proposal, rendering itself defunct.

It is expected that the decision would be implemented despite considerable scepticism among both PNB shareholders and IFCI employees with regard to the proposal. On his last day in office, the erstwhile Chairman and Managing Director of IFCI, V. P. Singh, sought to assuage the fears of PNB shareholders by saying that IFCI would clear most of its liabilities before the merger. Freed of them, PNB, in his view, could leverage IFCI's existing expertise on project financing, monitoring, advisory services and term-lending to complement its existing business.

Finally, recently the Parliament has approved the corporatisation of the IDBI, which had been debated for more than a year, paving the way for its merger with a bank as well. IDBI had earlier set up IDBI Bank as a subsidiary. However, the process of restructuring IDBI has involved converting the IDBI Bank into a stand alone bank, through the sale of IDBI's stake in the institution. Since there is no clear declaration that IDBI Bank would be chosen as the partner bank for the proposed merger of the DFI, talk of an alternative is very much in the air. Among the banks being mentioned are: Bank of Baroda, Punjab National Bank, Indian Bank and Canara Bank.

When the bill to corporatise IDBI was put through with some difficulty in the Rajya Sabha, it appeared that the government had provided two commitments. The first was that the government would retain a majority stake in the entity into which the IDBI would be transformed. The government currently has a 58.47 per cent stake in IDBI. And, second that the development finance emphasis of the institution would be retained. But already doubts are being expressed about the government's willingness to stick to the first of these commitments. And once the merger creates a universal bank as a new entity, with multiple interests and a strong emphasis on commercial profits, it is unclear how the second commitment can be met either.

As part of the corporatisation process, the IDBI has received a forbearance of five years with respect to the SLR requirement. It is however ready to meet the obligation of cash reserve ratio (CRR) of around Rs 2,000 crore to the RBI immediately. The SLR requirement for the institution is pegged at around Rs 18,000 crore. The non-performing assets (NPAs) of around Rs 15,000 crore are likely to be transferred out of the institution as and when the merger with a bank takes place.

These developments on the development banking front do herald a new era. An important financial intervention adopted by almost all late-industrialising developing countries, besides pre-emption of bank credit for specific purposes, was the creation of special development banks with the mandate to provide adequate, even subsidised, credit to selected industrial establishments and the agricultural sector. According to an OECD estimate quoted by Eshag, there were about 340 such banks operating in some 80 developing countries in the mid-1960s. Over half these banks were state-owned and funded by the exchequer, the remainder had a mixed ownership or were private. Mixed and private banks were given government subsidies to enable them to earn a normal rate of profit.

The principal motivation for the creation of such financial institutions was to make up for the failure of private financial agents to provide certain kinds of credit to certain kinds of clients. Private institutions may fail to do so because of high default risks that cannot be covered by high enough risk premiums because such rates are not viable. In other instances, failure may be because of the unwillingness of financial agents to take on certain kinds of risk, or because anticipated returns to private agents are much lower than the social returns in the investment concerned.

In practice, financial intermediaries seek to tailor the demands for credit from them with their funds by adjusting not just interest rates, but also the terms on which credit is provided. Lending gets linked to collateral, and the nature and quality of that collateral is adjusted according to the nature of the borrower and supply and demand conditions in the credit market. In the event, depending on the quantum and costs of funds available to the financial intermediary, the market tends to ration out borrowers to differing extents. In such circumstances, borrowers are rationed out because they are considered risky, but they may not be the ones that are the least important from a social point of view.

These problems can be aggravated because certain kinds of insurance markets for dealing with risk are absent and because in some (especially, developing-country) contexts, certain kinds of long-term contracts may not just exist. They need to be created by the state, and till such time state-backed lending would be needed to fill the gap.

Industrial development banks also help deal with the fact that local industrialists may not have adequate capital to invest in capacity of the requisite scale in more capital-intensive industries characterised by significant economies of scale. They help promote such ventures through their lending and investment practices and often provide technical assistance to their clients. Some development banks are expected to focus on the small scale industrial sector, providing them with long-term finance and working capital at subsidised interest rates and longer grace periods, as well as offering training and technical assistance in areas like marketing.

Fundamentally of course, development banking is required because social returns exceed private returns. This problem arises because private lenders are concerned only with the return they receive. On the other hand, the total return to a project includes the additional surplus (or profit) accruing to the entrepreneur. The projects that offer the best return to the lender may not be those with the highest total expected return. As a result, good projects get rationed out, necessitating measures such as development banking or directed credit.

Finally, directed credit has positive fiscal consequences. In contrast to subsidies, such credit reduces the demand placed on the government's own revenues. This makes directed credit an advantageous option in developing countries faced with chronic budgetary difficulties that limit their ability to use budgetary subsidies to achieve a certain allocation of investible resources.

It must be said that development banks have played an important role in the Indian context. In his deposition before the Parliamentary Standing Committee on Finance (1999-2000) on 18 September 2000, the Managing Director of ICICI stated: "disbursement by FIs constituted around fifty per cent of gross fixed capital formation by the private corporate sector in the pre-liberalised era. If you see the financial institutions' disbursement versus bank credit to industry right from 1951 to the last year, we see that financial institutions have provided significantly more credit for the creation of capital in industry in India. It has grown year after year … Thus, the FIs have played a pivotal role in the development of Indian industry and have fulfilled their initial objective i.e. to spur industrialisation in the country over the last three to four decades."

The corporatisation, transformation into universal banks and subsequent privatisation of the DFIs is bound to undermine this role of theirs. The justification for the conversion to universal banking as provided by the Industrial Investment Bank of India (IIBI) in a written reply to the Parliamentary Standing Committee indicates this: "Since compartmentalisation of activities leads to greater transactions cost and inefficiency, no financial intermediary can survive competition if it does not allow itself flexibility to change. In the new financial environment, IIBI is of the opinion that a financial player may be either placed naturally for resources like a commercial bank, or may be a pure financial service provider and retailer like the NBFCs. Still another option is to build a financial supermarket where all the services are available under a single umbrella. The advantages are that they would be free to choose the product mix of their operations and configure activities for optimum allocation of their resources."

The CEO of ICICI made clear what this means in terms of emphasis: "When we were set up, our role was to meet long term resource requirements of the industry. With liberalisation, the role has slightly changed. It became developing India's debt market, financing India's infrastructure development, etc. With globalisation, I think, the role is set to change further. Now we have to stress on profitability, shareholder value, corporate governance, while at the same time not losing sight of our goals – the goals that were originally set for us – and the goals that were set up in the interim with liberalisation." Unfortunately, the emphasis on those goals would remain only with regulation. But regulation is diluted by liberalisation.

There is another way in which the gradual dissolution of the core of India's development banking infrastructure is related to the process of liberalisation. This is through the effects of liberalisation on the profitability of an institution like the IFCI, for example. According to the D. Basu Expert Committee, which was appointed by IFCI's governing board immediately following its corporatisation and initial public offering in 1993, to examine the causes of the large NPAs accumulated by the institution and suggest a restructuring, IFCI embarked upon a programme of rapid expansion of business. To scale up the volume of business, it increasingly raised resources from the debt markets. This was at a time when interest rates were relatively high. In order to cover the high cost borrowings, the institution was forced to make investments in what were considered high yielding loan assets.

Unfortunately, this occurred at a time when financial liberalisation had put an end to the traditional consortium mode of lending, in which all major financial institutions collaborated in lending to a single borrower as per a mutually agreed pattern of sharing. Liberalisation was introducing an element of competition among financial institutions. In the event, in search of high returns IFCI chose to take relatively large exposures in several greenfield projects (notably in the steel and oil sectors).

For a number of reasons, these projects did not deliver on their promise. Many of these projects had expected to raise substantial equity from the capital market as well as from the internal resources of group companies. Depressed conditions in the capital market put paid to the first. Recessionary conditions limited the second. Many of these groups were in the traditional commodity sectors such as iron and steel, textiles, synthetic fibres, cement, sugar, basic chemicals, synthetic resins, plastics, etc. Besides the general recessionary environment, some of these sectors were particularly affected by the abolition of import controls and the gradual reduction of tariffs. Internal resource generation, therefore, fell short of expectations. As a result, with inadequate own-financing in the pipeline, many of these projects suffered from cost- and time-overruns.

Unlike other financial institutions, IFCI had not diversified into other types of businesses. Project finance still accounted for 94 per cent of IFCI's business assets. As a result, the impact of NPAs arising from the factors cited above was greater in the case of IFCI than in the case of other institutions. In addition, there was sharp rise in IFCI's gross NPA level in 1998-99 (Rs. 5,783.56 crore as against Rs. 4,159.84 crore in the previous year), as a result of the implementation of the mandatory RBI guidelines for classifying non-performing assets. As a result, certain loans, particularly those relating to projects under implementation, which had been treated as performing assets in earlier years, had to be classified as non-performing.

The Basu Committee had noted that some of the factors referred to above such as impact of trade policy liberalisation and tariff reduction, recessionary conditions in the late 1990s, depressed conditions in the capital market, etc., affected other DFIs and banks as well. However, the impact was particularly pronounced in the case of IFCI, as the concentration of risk relative to net worth was much higher. Also, as already stated, other DFIs had started diversifying into non-project related lending business. It was difficult to survive as a development finance institution in the new environment.

Thus, the decline of development finance is clearly related to the process of economic liberalisation. However, as a number of industry associations have noted in recent times, it hardly is true that in a time of growing competition for Indian firms from international business and a growing liberalisation-induced shift in the investment and lending practices of banks and NBFCs away from manufacturing, state support for domestic private investment is not insignificant.

The view that development finance does not matter is countered by the fact that thus far, right through the years of liberalisation, the state has been forced to maintain a high ratio of disbursement of financial institutions to Gross Domestic Capital Formation in the private corporate sector (Chart 1). That ratio has risen sharply in recent times. However, the argument that development finance is irrelevant is backed up by evidence that in the case of many new projects, the share of equity finance in total resources is quite high (Chart 2). The stock market is replacing the DFIs, it is claimed. But such evidence is based on information collected by the Department of Company Affairs from firms that have issued prospectuses. That is, they are firms that have the ability to and have chosen to tap capital markets and have hence issued prospectuses. But, it is not clear whether these firms actually managed to raise the requisite capital from equity markets. And though the number of such projects is growing, it still remains small (Chart 3). Further, the number of such projects is quite volatile. Thus, relying on these figures to justify undermining a framework that has served Indian industry well is completely unwarranted. But, the reasons why these arguments are purveyed is that they serve as the basis for justifying the government's decision to adopt large-scale financial liberalisation in its bid to attract and appease international financial capital. In that framework of policy, support for building a domestic manufacturing base obviously does not make sense.



Themes > Features	17.03.2004


The End of Development Finance

Close to two years back, on March 30 2002, the Industrial Credit and Investment Corporation of India (ICICI) was through a reverse merger, integrated with ICICI Bank. That was the beginning of a process that is leading to the demise of development finance in the country. The reverse merger was the result of a decision (announced on October 25, 2001) by the ICICI to transform itself into a universal bank that would engage itself not only in traditional banking, but also investment banking and other financial activities. The proposal also involved merging ICICI Personal Financial Services Ltd and ICICI Capital Services Ltd with the bank, resulting in the creation of a financial behemoth with assets of more than Rs. 95,000 crore. The new company was to become the first entity in India to serve as a financial supermarket and offer almost every financial product under one roof. Since the announcement of that decision, not only has the merger been put through, but similar moves are underway to transform the other two principal development finance institutions in the country, the Industrial Finance Corporation of India (IFCI), established in 1948, and the Industrial Development Bank of India (IDBI), created in 1964. In early February, Finance Minister Jaswant Singh announced the government's decision to merge the IFCI with a big public sector bank, like the Punjab National Bank. Following that decision, the IFCI board has approved the proposal, rendering itself defunct. It is expected that the decision would be implemented despite considerable scepticism among both PNB shareholders and IFCI employees with regard to the proposal. On his last day in office, the erstwhile Chairman and Managing Director of IFCI, V. P. Singh, sought to assuage the fears of PNB shareholders by saying that IFCI would clear most of its liabilities before the merger. Freed of them, PNB, in his view, could leverage IFCI's existing expertise on project financing, monitoring, advisory services and term-lending to complement its existing business. Finally, recently the Parliament has approved the corporatisation of the IDBI, which had been debated for more than a year, paving the way for its merger with a bank as well. IDBI had earlier set up IDBI Bank as a subsidiary. However, the process of restructuring IDBI has involved converting the IDBI Bank into a stand alone bank, through the sale of IDBI's stake in the institution. Since there is no clear declaration that IDBI Bank would be chosen as the partner bank for the proposed merger of the DFI, talk of an alternative is very much in the air. Among the banks being mentioned are: Bank of Baroda, Punjab National Bank, Indian Bank and Canara Bank. When the bill to corporatise IDBI was put through with some difficulty in the Rajya Sabha, it appeared that the government had provided two commitments. The first was that the government would retain a majority stake in the entity into which the IDBI would be transformed. The government currently has a 58.47 per cent stake in IDBI. And, second that the development finance emphasis of the institution would be retained. But already doubts are being expressed about the government's willingness to stick to the first of these commitments. And once the merger creates a universal bank as a new entity, with multiple interests and a strong emphasis on commercial profits, it is unclear how the second commitment can be met either. As part of the corporatisation process, the IDBI has received a forbearance of five years with respect to the SLR requirement. It is however ready to meet the obligation of cash reserve ratio (CRR) of around Rs 2,000 crore to the RBI immediately. The SLR requirement for the institution is pegged at around Rs 18,000 crore. The non-performing assets (NPAs) of around Rs 15,000 crore are likely to be transferred out of the institution as and when the merger with a bank takes place. These developments on the development banking front do herald a new era. An important financial intervention adopted by almost all late-industrialising developing countries, besides pre-emption of bank credit for specific purposes, was the creation of special development banks with the mandate to provide adequate, even subsidised, credit to selected industrial establishments and the agricultural sector. According to an OECD estimate quoted by Eshag, there were about 340 such banks operating in some 80 developing countries in the mid-1960s. Over half these banks were state-owned and funded by the exchequer, the remainder had a mixed ownership or were private. Mixed and private banks were given government subsidies to enable them to earn a normal rate of profit. The principal motivation for the creation of such financial institutions was to make up for the failure of private financial agents to provide certain kinds of credit to certain kinds of clients. Private institutions may fail to do so because of high default risks that cannot be covered by high enough risk premiums because such rates are not viable. In other instances, failure may be because of the unwillingness of financial agents to take on certain kinds of risk, or because anticipated returns to private agents are much lower than the social returns in the investment concerned. In practice, financial intermediaries seek to tailor the demands for credit from them with their funds by adjusting not just interest rates, but also the terms on which credit is provided. Lending gets linked to collateral, and the nature and quality of that collateral is adjusted according to the nature of the borrower and supply and demand conditions in the credit market. In the event, depending on the quantum and costs of funds available to the financial intermediary, the market tends to ration out borrowers to differing extents. In such circumstances, borrowers are rationed out because they are considered risky, but they may not be the ones that are the least important from a social point of view. These problems can be aggravated because certain kinds of insurance markets for dealing with risk are absent and because in some (especially, developing-country) contexts, certain kinds of long-term contracts may not just exist. They need to be created by the state, and till such time state-backed lending would be needed to fill the gap. Industrial development banks also help deal with the fact that local industrialists may not have adequate capital to invest in capacity of the requisite scale in more capital-intensive industries characterised by significant economies of scale. They help promote such ventures through their lending and investment practices and often provide technical assistance to their clients. Some development banks are expected to focus on the small scale industrial sector, providing them with long-term finance and working capital at subsidised interest rates and longer grace periods, as well as offering training and technical assistance in areas like marketing. Fundamentally of course, development banking is required because social returns exceed private returns. This problem arises because private lenders are concerned only with the return they receive. On the other hand, the total return to a project includes the additional surplus (or profit) accruing to the entrepreneur. The projects that offer the best return to the lender may not be those with the highest total expected return. As a result, good projects get rationed out, necessitating measures such as development banking or directed credit. Finally, directed credit has positive fiscal consequences. In contrast to subsidies, such credit reduces the demand placed on the government's own revenues. This makes directed credit an advantageous option in developing countries faced with chronic budgetary difficulties that limit their ability to use budgetary subsidies to achieve a certain allocation of investible resources. It must be said that development banks have played an important role in the Indian context. In his deposition before the Parliamentary Standing Committee on Finance (1999-2000) on 18 September 2000, the Managing Director of ICICI stated: "disbursement by FIs constituted around fifty per cent of gross fixed capital formation by the private corporate sector in the pre-liberalised era. If you see the financial institutions' disbursement versus bank credit to industry right from 1951 to the last year, we see that financial institutions have provided significantly more credit for the creation of capital in industry in India. It has grown year after year … Thus, the FIs have played a pivotal role in the development of Indian industry and have fulfilled their initial objective i.e. to spur industrialisation in the country over the last three to four decades." The corporatisation, transformation into universal banks and subsequent privatisation of the DFIs is bound to undermine this role of theirs. The justification for the conversion to universal banking as provided by the Industrial Investment Bank of India (IIBI) in a written reply to the Parliamentary Standing Committee indicates this: "Since compartmentalisation of activities leads to greater transactions cost and inefficiency, no financial intermediary can survive competition if it does not allow itself flexibility to change. In the new financial environment, IIBI is of the opinion that a financial player may be either placed naturally for resources like a commercial bank, or may be a pure financial service provider and retailer like the NBFCs. Still another option is to build a financial supermarket where all the services are available under a single umbrella. The advantages are that they would be free to choose the product mix of their operations and configure activities for optimum allocation of their resources." The CEO of ICICI made clear what this means in terms of emphasis: "When we were set up, our role was to meet long term resource requirements of the industry. With liberalisation, the role has slightly changed. It became developing India's debt market, financing India's infrastructure development, etc. With globalisation, I think, the role is set to change further. Now we have to stress on profitability, shareholder value, corporate governance, while at the same time not losing sight of our goals – the goals that were originally set for us – and the goals that were set up in the interim with liberalisation." Unfortunately, the emphasis on those goals would remain only with regulation. But regulation is diluted by liberalisation. There is another way in which the gradual dissolution of the core of India's development banking infrastructure is related to the process of liberalisation. This is through the effects of liberalisation on the profitability of an institution like the IFCI, for example. According to the D. Basu Expert Committee, which was appointed by IFCI's governing board immediately following its corporatisation and initial public offering in 1993, to examine the causes of the large NPAs accumulated by the institution and suggest a restructuring, IFCI embarked upon a programme of rapid expansion of business. To scale up the volume of business, it increasingly raised resources from the debt markets. This was at a time when interest rates were relatively high. In order to cover the high cost borrowings, the institution was forced to make investments in what were considered high yielding loan assets. Unfortunately, this occurred at a time when financial liberalisation had put an end to the traditional consortium mode of lending, in which all major financial institutions collaborated in lending to a single borrower as per a mutually agreed pattern of sharing. Liberalisation was introducing an element of competition among financial institutions. In the event, in search of high returns IFCI chose to take relatively large exposures in several greenfield projects (notably in the steel and oil sectors). For a number of reasons, these projects did not deliver on their promise. Many of these projects had expected to raise substantial equity from the capital market as well as from the internal resources of group companies. Depressed conditions in the capital market put paid to the first. Recessionary conditions limited the second. Many of these groups were in the traditional commodity sectors such as iron and steel, textiles, synthetic fibres, cement, sugar, basic chemicals, synthetic resins, plastics, etc. Besides the general recessionary environment, some of these sectors were particularly affected by the abolition of import controls and the gradual reduction of tariffs. Internal resource generation, therefore, fell short of expectations. As a result, with inadequate own-financing in the pipeline, many of these projects suffered from cost- and time-overruns. Unlike other financial institutions, IFCI had not diversified into other types of businesses. Project finance still accounted for 94 per cent of IFCI's business assets. As a result, the impact of NPAs arising from the factors cited above was greater in the case of IFCI than in the case of other institutions. In addition, there was sharp rise in IFCI's gross NPA level in 1998-99 (Rs. 5,783.56 crore as against Rs. 4,159.84 crore in the previous year), as a result of the implementation of the mandatory RBI guidelines for classifying non-performing assets. As a result, certain loans, particularly those relating to projects under implementation, which had been treated as performing assets in earlier years, had to be classified as non-performing. The Basu Committee had noted that some of the factors referred to above such as impact of trade policy liberalisation and tariff reduction, recessionary conditions in the late 1990s, depressed conditions in the capital market, etc., affected other DFIs and banks as well. However, the impact was particularly pronounced in the case of IFCI, as the concentration of risk relative to net worth was much higher. Also, as already stated, other DFIs had started diversifying into non-project related lending business. It was difficult to survive as a development finance institution in the new environment. Thus, the decline of development finance is clearly related to the process of economic liberalisation. However, as a number of industry associations have noted in recent times, it hardly is true that in a time of growing competition for Indian firms from international business and a growing liberalisation-induced shift in the investment and lending practices of banks and NBFCs away from manufacturing, state support for domestic private investment is not insignificant. The view that development finance does not matter is countered by the fact that thus far, right through the years of liberalisation, the state has been forced to maintain a high ratio of disbursement of financial institutions to Gross Domestic Capital Formation in the private corporate sector (Chart 1). That ratio has risen sharply in recent times. However, the argument that development finance is irrelevant is backed up by evidence that in the case of many new projects, the share of equity finance in total resources is quite high (Chart 2). The stock market is replacing the DFIs, it is claimed. But such evidence is based on information collected by the Department of Company Affairs from firms that have issued prospectuses. That is, they are firms that have the ability to and have chosen to tap capital markets and have hence issued prospectuses. But, it is not clear whether these firms actually managed to raise the requisite capital from equity markets. And though the number of such projects is growing, it still remains small (Chart 3). Further, the number of such projects is quite volatile. Thus, relying on these figures to justify undermining a framework that has served Indian industry well is completely unwarranted. But, the reasons why these arguments are purveyed is that they serve as the basis for justifying the government's decision to adopt large-scale financial liberalisation in its bid to attract and appease international financial capital. In that framework of policy, support for building a domestic manufacturing base obviously does not make sense.



© MACROSCAN 2004